Foreign Institutional Ownership and the Global Convergence of Financial Reporting

Vivian Fang is an Assistant Professor of Accounting at the University of Minnesota. This post based on an article by Professor Fang, Mark Maffett, Assistant Professor of Accounting at the University of Chicago, and Bohui Zhang, Associate Professor at the School of Banking and Finance, University of New South Wales.

In our recent paper, Foreign Institutional Ownership and the Global Convergence of Financial Reporting Practices, forthcoming in the Journal of Accounting Research, we examine the role of foreign institutional investors in the global convergence of financial reporting practices. Regulators frequently espouse comparability as a desirable characteristic of financial reporting to facilitate investment decision-making and allocation of capital. Over the past 15 years, significant regulatory effort has gone into promoting comparability, the most prominent example of which is the International Accounting Standards Board’s (IASB) push for global adoption of International Financial Reporting Standards (IFRS). However, recent research (e.g., Daske, Hail, Leuz, and Verdi [2008], Christensen, Hail, and Leuz [2013]) shows that mandating the use of a common set of accounting standards alone is unlikely to achieve financial reporting convergence.

The documented ineffectiveness of regulatory mandates suggests that alternative mechanisms capable of altering firms’ equilibrium reporting practices likely contribute to the significant global reporting convergence observed over the past three decades (e.g., Land and Lang [2002]). One potential mechanism is investor demand for more comparable reporting. Prior research argues that foreign institutional investors prefer comparable financial reporting because it reduces information processing costs and improves investment efficiency (e.g., Bradshaw, Bushee, and Miller [2004], Covrig, DeFond, and Hung [2007], DeFond, Hu, Hung, and Li [2011]). These studies suggest that institutional investors primarily take a passive approach, seeking out firms that already have high levels of accounting comparability, rather than actively promoting reporting convergence. It remains unclear whether, and to what extent, foreign institutional investors directly affect the convergence of reporting practices. In this paper, we aim to directly tackle this question.

We have three important findings. First, using a sample of firms from 18 emerging markets and 20 developed markets from 1998 to 2009, we find that both higher levels and larger changes in ownership by U.S. mutual funds are positively associated with subsequent increases in firms’ comparability to U.S. firms, but primarily only for firms domiciled in emerging markets—a finding we attribute to the importance of external, market-based monitoring in the face of weak regulatory infrastructures. As measures of comparability to U.S. firms, we use the output-based approach suggested by De Franco, Kothari, and Verdi [2011], a firm’s likelihood of choosing an accounting treatment that conforms to U.S. reporting standards, a firm’s likelihood of voluntarily adopting an internationally recognized set of accounting standards, a firm’s likelihood of producing English-language financial statements, and a firm’s accrual quality and earnings smoothness.

To establish causality for our first finding, we employ an instrumental variable approach that exploits an exogenous shock to the level of U.S. investment—the passage of the Jobs and Growth Tax Relief Reconciliation Act in 2003. Desai and Dharmapala [2011] document that, following JGTRRA, U.S. institutional investors reallocated their portfolios toward the equities of firms eligible for the Act’s dividend tax cut and, as a result, U.S. ownership in these firms increased significantly compared to that in ineligible firms. We find that JGTRRA-eligible firms experienced a significant improvement in their comparability to U.S. firms subsequent to the passage of the Act. We undertake a battery of robustness tests to mitigate other econometric concerns. Collectively, these tests provide evidence of a direct effect of U.S. institutional investors on comparability to U.S. firms.

As our second finding, we propose and establish a specific mechanism—a firm’s choice of auditor—through which U.S. institutional investors might affect firms’ reporting comparability. Because the Big Four audit firms play a significant role in shaping U.S. firms’ reporting behavior, if an institutional investor induces a firm to switch to a Big Four auditor, this will likely enhance the firm’s comparability to U.S. firms. Consistent with this prediction, we find that non-U.S. firms with higher U.S. institutional investment are more likely to switch to a Big Four auditor and that this switch is associated with a subsequent improvement in these firms’ comparability to U.S. firms.

Finally, we shed light on the economic consequences of increased international comparability for foreign financial statement users. We show that both the level and the change in comparability to U.S. firms are positively associated with an increase in foreign analyst following and a decrease in foreign analyst forecast error and dispersion.

Our study makes several contributions to the existing literature and carries important policy implications. Foremost, our paper is the first to establish U.S. institutional investment as an economically important determinant of global financial reporting convergence and thus highlight the role of market forces in shaping financial reporting practices, particularly in the face of a weak regulatory infrastructure. The weak regulatory infrastructures present in many countries create little incentive for firms to voluntarily improve their financial reporting practices. In the absence of such incentives, regulatory mandates that intend to increase comparability are unlikely to be effective. Given the questionable effectiveness and substantial implementation costs involved with mandatory reporting changes, it is important to understand alternative mechanisms that could precipitate meaningful accounting changes. Our results demonstrate that U.S. institutional investors can serve as such a mechanism. Second, we provide evidence of a specific channel—the choice of audit firm—through which institutional investors directly affect reporting convergence. Finally, we add to the growing literature examining the economic consequences of foreign investment (e.g., Bekaert and Harvey [2000], Ferreira and Matos [2008], Ferreira, Massa, and Matos [2010]) by documenting a positive effect of U.S. institutional investors on the informativeness of non-U.S. firms’ financial statements for foreign users.

The full paper is available for download here.

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